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Trash or Treasure: Skechers U.S.A.

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Note: The formatting for this post got completely botched when I copied it over from the Open Office file. I've tried to fix it as best as I can, but I haven't been able to clean everything up and it looks about 100 * better in the Open Office file. Therefore, if you want to read this but find the formatting too terrible, feel free to e-mail me at hallshadowcaps at gmail.com to request a copy of the original file. I will try to have it to you within a day.

I know I haven't released anything besides updates on Samson Oil & Gas for awhile (I have an update forthcoming – short story, I've sold most of my position at a massive profit), but here's an analysis of Skechers, its management, business divisions, working capital, valuation, and risks. This isn't intended to be a buy or sell recommendation, it's just what I think about the company and its prospects. This is the first time I've put my thoughts to paper with "conventional" analysis, and you should know this isn't really my cup of tea when it comes to the investing universe. I was trying to get this out within two days, but life had other plans and it ended up taking nearly three weeks. After writing this, I don't realistically think I could have published it in anything less than three or four days in the best of circumstances due to the amount of data I had to scour. Nevertheless, I've put a decent amount of time into this blog so I hope you all enjoy it.

Numbers may not add due to rounding, but the net income number is always as reported in the SEC filings.

Business Background

Founded in 1992, Skechers manufactures and distributes a wide range of athletic and casual footwear for men, women and children. Some of its products include Skechers Shape-Ups, toning shoes targeted primarily at women, casual shoes for men and women, and products targeted towards children such as Hydee Hytops, Sporty Shorty, and Twinkle Toes for girls, and Luminators and Hot Lights for boys. Many of the company's products aimed towards children light up or are bedazzled, which apparently causes them to carry lower gross margins than shoes targeted towards adults.

Skechers has the second largest market share of the footwear apparel industry in the United States, second only to Nike.

The company has four distinct business segments: Domestic Wholesale, International Wholesale, Retail, and E-Commerce. Skechers directly sells its products directly to consumers through its retail stores and websites, and sells its products to department, athletic, and specialty stores through its wholesale divisions.

Skechers had 47,627,769 shares outstanding as of its most recent quarter and 46,604,703 outstanding as of the end of 2009. Skechers has two classes of stock: Class A and Class B. Both classes are entitled to the same economic interest per share, but the Class B shares are entitled to ten votes per share while the Class A shares are entitled to just one. Skechers Class A stock trades on the New York Stock Exchange, where its most recent closing price was $22.81 per share.

One of the most important, yet often neglected, things about a company is the quality of its management. How much experience does management have? Are their interests aligned with the shareholders of the company? Does management act with integrity? These are all important issues to consider. With that in mind, let's see how Skechers stacks up.

∙Experience

Skechers is a family-controlled company, so it is not surprising to see that many Skechers executives have a similar amount of experience in the footwear industry. Robert Greenberg, the founder and CEO, has been with the company since its inception in 1992. His sons, Michael and Jeffrey Greenberg, have twenty-six and twenty-one years of experience in the footwear industry, respectively. David Weinberg has twenty-one years of experience. The company does not give much detail regarding the rest of the executives' experience in the industry.

Cumulatively, management has more than eighty years of experience in the footwear apparel industry and has lead the company to two billion dollars of sales and the second largest market share of the footwear apparel industry in the United States. A big issue of concern to me in management is that the positions of COO and CFO are held by the same individual, David Weinberg. Holding both the COO and CFO positions may lend itself to ethical concerns, and I would prefer to see the positions held by separate individuals.

∙Inside Ownership

Inside ownership is exceptionally high in this company, with management directly owning a whopping 27.74% of the company's stock as of the end of 2009. Due to the company's dual class share structure, management's voting interest is even higher at 40.939%. The remaining Class B shares are held by other members of the Greenberg family and trusts established by the Greenbergs for the benefit of their family. Including all outstanding Class B shares, management directly or indirectly controls 41.936% of the economic interest and 82.855% of the voting interest in the company. In this regard, management's high ownership of the company's stock is a double-edged sword. While management does have an incentive to perform well for the shareholders given their own large holdings, at the end of the day this is a family-controlled company and whatever the Greenbergs say goes, for better or worse.

∙Executive Compensation

Top executives were paid a total of $18,499,714 during 2009, broken down as follows.

Robert Greenberg $2,221,699

Michael Greenberg $7,282,769

David Weinberg $3,795,257

Philip Paccione $1,867,472

Mark Nason $2,710,104

Frederick Schneider $622,413

Executive compensation was up from $8,288,575 in 2009, and was 1.287% of total revenue, up from 0.575% of total revenue in 2008.

Skechers has two management incentive plans in effect as of this writing, the 2006 Annual Incentive Compensation Plan and the 2007 Incentive Award Plan. Under the 2006 Annual Incentive Compensation Plan, management can be awarded additional cash compensation above and beyond their base pay if certain performance targets are met. Management recommends these performance targets to the company's Compensation Committee each year for its approval. After each quarter, the Compensation Committee meets to certify the bonuses earned by each executive during the quarter.

The "performance targets" that the company uses for the 2006 Plan are somewhat vague – in 2009, the targets were the same as 2008's which were "based upon the company's net sales and net income" figures. Management was paid a total of $2,823,447 under the plan in 2009 compared to $2,118,328 despite net sales and net income declining by 0.299% and 1.258% respectively, year-over-year. I suppose management has set its performance targets so that its compensation is inversely correlated to the company's sales and earnings growth. All kidding aside, I would like management to provide more color on the 2006 Annual Incentive Compensation Plan than it does; the information they choose to share about it right now is vague and lends itself to confusion.

The 2007 Incentive Award Plan allows for Skechers to give management restricted stock and stock options as a component of their compensation. While the 2007 Plan allows for the granting of options, Skechers has not actually exercised that ability since February of 2004. Instead, Skechers has elected to hand out restricted stock like candy under the rationale that it requires fewer shares to be issued to give executives the same amount of economic value when compared to stock options. In my opinion, this is an excuse for the company to give away more of the shareholders' money for less productivity from management. With options, management would have more of an incentive to improve the company's fundamentals in order to boost the stock price above the strike price of their options. With stock awards, management doesn't have to worry as much about the price of the equity, since regardless of what happens (bar bankruptcy), they will always be better off than they were before the stock was issued.

I am of the opinion that the company's incentive plans and policies are vague and ill-conceived, and I would prefer to see Skechers resume using options in lieu of stock awards. The company's current policy has the potential to breed laziness and is not in the best interests of outside shareholders.

Recent History – Business Stagnation & Turning the Page?

Revenue COGS GrossProf. SG&A NI&O Pretax Taxes NCI NetIncome

TQ310 $1.555b $825mm $731mm $536mm $0mm $196mm $63mm $0mm $132.911mm

TQ309 $1.049b $616mm $433mm $402mm $2mm $33mm $8mm $2mm $26.753mm

Q310 $556mm $302mm $255mm $199mm -$3mm $53mm $16mm $0mm $36.378mm

Q309 $406mm $222mm $184mm $152mm $2mm $34mm $10mm $1mm $24.460mm

FY09 $1.438b $815mm $623mm $550mm -$1mm $71mm $0mm $4mm $54.699mm

FY08 $1.443b $845mm $598mm $540mm $3mm $61mm $7mm $2mm $55.396mm

FY07 $1.394b $794mm $604mm $491mm $5mm $118mm $43mm $0mm $75.686mm

FY06 $1.205b $682mm $527mm $415mm $0mm $113mm $42mm $0mm $70.994mm

From 2006 through 2009, Skechers had been in a period of stagnation as a business, largely due to the Great Recession and the fact that the company's growth in revenue was accompanied by disproportionate growth in expenses. Whether due to the company's costs of goods sold increasing, varying tax liability, or the rise in administrative expenses largely because of increased employee salaries and benefits, Skechers suffered from deteriorating financial performance for nearly the entire timeframe; earnings declined by nearly 23% from 2006 to 2009 while revenue increased by 19.33% during the same period.

With the introduction of Skechers Shape-Ups, Skechers' fortunes changed. The company is now growing revenue and earnings at a rapid clip, up 48.23% and 396.80% during the first nine months of 2010. Despite (or more likely because of) its newfound success, the company's operations have actually eaten cash during the first nine months of 2010 – although revenue and earnings are through the roof, inventories receivables have shot up by $101,911,000 and $63,355,000 respectively, resulting in operations consuming $766,000 of the company's cash in the bank.

Unfortunately, the success Skechers has had with its Shape-Ups may be short-lived. There is significant controversy around Shape-Ups and other "toning" shoes regarding whether the health claims producers make about them are accurate. According to the APMA, there are some orthopedic benefits to toning shoes, and the APMA has given its "Seal of Approval" to some toning shoes. No products by Skechers were among them. There appears to be no evidence that indicates these shoes will significantly tone a person's thighs or buttocks, contrary to the claims of the companies producing them.

Revenue and earnings are broken down by segment as follows. Keep in mind that Skechers doesn't allocate any SG&A expenses to its divisions, instead choosing to aggregate them. As a result of this, not all of the costs incurred by a given division will be included below because management has elected not to share that information with us.

∙Domestic Wholesale

Revenue GrossProfit Margin APPU

TQ310 $904.066mm $387.478mm 42.85% $24.81

TQ309 $544.352mm $194.715mm 35.77% $19.17

Q310 $312.319mm $129.496mm 41.46% $25.87

Q309 $202.963mm $82.328mm 40.56% $21.71

FY09 $763.514mm $292.303mm 38.28% $20.49

FY08 $807.047mm $276.604mm 34.27% $19.21

FY07 $831.235mm $320.364mm 38.54% $19.22

FY06 $772.920mm $301.251mm 38.97% $19.44

The Domestic Wholesale division sells Skechers products to department, atheltic specialty shoe stores, specialty stores and catalog and Internet retailers. This division – the company's largest by revenue and gross profit, has had a banner year in 2010. Sales have increased by 66.08% year-over-year during the first nine months of 2010, with divisional profits increasing by an even more impressive 98.99% as a result of margin expansion due to the higher average price per unit sold.

We can really see the impact Shape-Ups have had on the company's performance here – as the popularity of toning shoes has increased and toning shoes have become a larger percentage of revenue, margins have marched steadily higher. While Shape-Ups have been commercially successful, their success has caused an inventory problem for the company; Skechers recorded a massive $101,000,000 increase of inventories in the third quarter of 2010 resulting from customer order cancellations. According to David Weinberg at the ICR Xchange Conference held on January 13th, 2010, Skechers is beginning to move through its increased inventory, but gross margins may dip below 40% temporarily as the company tries to clear out all of its old merchandise. The company's goal is to head in to the second half of 2011 with a clean inventory, consisting of all-new products.

∙International Wholesale

Revenue GrossProfit Margin

TQ310 $325.751mm $138.073mm 42.38%

TQ309 $261.140mm $93.127mm 35.66%

Q310 $124.623mm $52.070mm 41.78%

Q309 $100.099mm $39.281mm 39.24%

FY09 $328.466mm $118.440mm 36.05%

FY08 $332.503mm $137.840mm 41.45%

FY07 $267.648mm $99.759mm 37.27%

FY06 $183.687mm $65.034mm 35.40%

No, there isn't an oversight in the above table (EDITOR'S NOTE: But there are a lot of formatting errors). Despite management being very bullish on the future growth prospects of the International Wholesale division, for whatever reason they have decided not to share the average price per unit sold by the division. This is odd considering that management not only releases this information for the Domestic Wholesale division, they emphasize it and compare the average price to prior periods. Since management doesn't supply this information for the International Wholesale division, I decided to try to get it through a back door – if we divide the International Wholesale division's revenue by the number of units sold, we can calculate the average price per unit sold ourselves. There's just one problem with that. Management doesn't supply the number of units sold for this division, either! I do not know why management is inconsistent in what information it decides to share with the shareholders of the company, but when attempting to perform research on the company it is certainly annoying.

Fortunately we can, however, use numbers from the Domestic Wholesale division to calculate a very rough estimate of the number of units sold and the average selling price per unit of the International Wholesale division. If we take the COGS of the Domestic Wholesale division and divide by the number of units sold in any given period, we can calculate the average cost per unit sold for the Domestic Wholesale division. From there, we can divide the International Wholesale division's COGS by the average cost per unit of the Domestic Wholesale division to get an estimate of the number of units sold by the International Wholesale division. Finally, we can take the revenue for the period and divide it by our estimate of the number of units sold to reach an estimated average price per unit sold.

This will not be exact, because it does not account for the difference between the division's fixed and variable costs or the differences that may exist between the costs of the Domestic Wholesale and International Wholesale divisions, but it is the best that we can do with the information management has chosen to share with us. Below is the updated table with rough estimates for the average price per unit sold, calculated as described in the previous paragraph.

Revenue GrossProfit Margin EstAPPU

TQ310 $325.751mm $138.073mm 42.38% $24.606

TQ309 $261.140mm $93.127mm 35.66% $19.137

Q310 $124.623mm $52.070mm 41.78% $26.012

Q309 $100.099mm $39.281mm 39.24% $21.238

FY09 $328.466mm $118.440mm 36.05% $19.775

FY08 $332.503mm $137.840mm 41.45% $21.566

FY07 $267.648mm $99.759mm 37.27% $18.830

FY06 $183.687mm $65.034mm 35.40% $18.365

If you compare the estimated average price per unit for the International Wholesale division to the actual average price per unit for the Domestic Wholesale division, you'll see that they're generally not far apart. I think that these estimates are reasonably accurate, but I would like to see Skechers management become more consistent with the information that it provides by division so that we can have official numbers in the future. Ranting aside, we can continue.

The International Wholesale division sells Skechers products to its foreign subsidiaries, department and specialty stores, and to distributors in regions that Skechers not sell its products directly. It has been more consistent in growth than the Domestic Wholesale division in recent years, growing in all but one year since 2006. Its growth hasn't been as impressive as the Domestic Wholesale division's this year, however, growing revenue and earnings by "just" 24.74% and 48.26%, respectively. Management is very bullish on this division of the company, believing that it will provide substantial revenue and earnings growth into the future as the company expand into and develops its presence in newer markets.

∙Retail

Revenue GrossProfit Margin DStores IStores

TQ310 $301.410mm $191.156mm 63.42%

TQ309 $227.541mm $136.113mm 59.81%

Q310 $111.825mm $68.043mm 60.84% 235 40

Q309 $95.250mm $54.449mm 57.16% 218 26

FY09 $321.829mm $198.243mm 61.59% 219 27

FY08 $283.128mm $172.870mm 61.05% 204 19

FY07 $279.361mm $171.758mm 61.48% 177 16

FY06 $237.390mm $151.456mm 63.80% 144 12

Unsurprisingly for a company with two wholesale divisions, this division has the best gross margins in the company by far. The company has grown its store count to 275 worldwide as of the third quarter of 2010, up from 244 in the same quarter the prior year.

At the ICR Xchange conference, management once again put its ability to be vague on display when David Weinberg said that the company expects the Retail division to grow by "40 to 50" in 2011. Those were his words. He did not explain if he meant the company was going to grow 40% to 50%, whether the company was going to open 40 to 50 additional retail stores in 2011, or both. Given that the company has only managed to grow revenue of the retail division by 32.54% in the first nine months of 2010, slowing to just 17.40% year-over-year in the third quarter, I suspect that David Weinberg meant that the store count was going to increase by 40 to 50 in 2011. I do not know that for a fact, but it seems much more realistic given the company's already-declining growth in this division and that, in all likelihood, gross margins will be lower for at least the first half of 2011 as the company works off its inventory overhang (or is it hangover?).

Skechers has three distinct types of retail stores – concept stores, factory outlet stores, and wholesale outlet stores. The amount and purposes of each type of store is as follows.

1. Concept Stores

Dom. Int.

Q310 101 25

Q309 87 21

FY09 90 22

FY08 84 16

FY07 70 13

FY06 50 10

According to Skechers, concept stores are used by the company to showcase a large percentage of its product line, increase its brand presence, and to test new marketing strategies and products before wide distribution. These stores are located in major malls in large cities and on "marquee" streets with lots of foot traffic (think Times Square). Management thinks that sales in the concept stores can be used to help forecast sales for customers of its wholesale divisions, and shares those sales numbers with its customers.

Although not explicitly mentioned by management in various 10-K and 10-Q filings of Skechers, we can infer that these stores have the highest margins of any of the company's three retail store types due management stating that the Retail division's margins were higher or lower in a given period due to an increase or decrease in sales at the company's factory outlet and warehouse outlet stores, respectively.

2. Factory Outlet Stores

Dom. Int.

Q310 96 15

Q309 93 5

FY09 92 5

FY08 83 3

FY07 72 2

FY06 61 2

Skechers' factory outlet stores are used to sell discontinued products or excess inventory which would otherwise have to be sold to discounters for very low prices. These stores are located in outlet malls and are supplemented by first-run, full-price merchandise to avoid compromising the "brand image." Skechers was on a binge with these stores internationally in 2010, having opened 10 of them overseas as of the third quarter – bringing them to triple the prior year's international store count. In terms of size, the factory outlet stores typically run between 1,900 and 9,000 square feet.

3. Warehouse Outlet Stores

Dom. Int.

Q310 38 0

Q309 37 0

FY09 37 0

FY08 37 0

FY07 35 0

FY06 33 0

These are the factory outlet stores, but freestanding and bigger. While the factory outlet stores are 1,900 to 9,000 square feet, the warehouse outlet stores are usually between 5,200 and 13,500 square feet. These aren't as widespread as the company's concept or factory outlet stores, and they're used exclusively to get rid of merchandise the company isn't interested in anymore. Skechers makes a point to place there near their concept stores so that they can transfer and dispose of slow-moving, odd-sized, and discontinued inventory as quickly as possible. Virtually all of these stores are located inside the United States, and Skechers has been slow to open more of them when compared to the concept and factory outlet stores.

∙E-Commerce

Revenue GrossProfit Margin

TQ310 $21.022mm $11.007mm 52.35%

TQ309 $14.787mm $7.803mm 52.76%

Q310 $5.859mm $3.042mm 51.92%

Q309 $7.062mm $3.668mm 51.93%

FY09 $22.631mm $12.024mm 53.13%

FY08 $18.065mm $8.608mm 47.65%

FY07 $15.937mm $8.108mm 50.87%

FY06 $11.371mm $5.641mm 49.60%

This is Skechers' smallest official division of the company, although the sales it does produce enjoy high gross margins. The E-Commerce division represents all of Skechers' sales from their various websites, most notably Skechers.com. There's really not much to say about this division – it's tiny (about 1.35% of revenue) and is not of major importance to the company.

∙Licensing

Revenue

TQ310 $3.148mm

TQ309 $1.021mm

Q310 $1.888mm

Q309 $0.418mm

FY09 $1.655mm

FY08 $2.461mm

FY07 $4.179mm

FY06 $4.114mm

This isn't technically a division of its own and management does not appear to assign any costs to it, and revenue from this "division" has been on a downward trend for years and makes up a very small percentage of the company's revenue. Nevertheless, it's seemingly almost all profit so I thought it was worth mentioning.

A company's fortunes (get it?) don't end at the income statement. To see how much money a company is actually bringing in the doors and the quality of a company's earnings, it's necessary to take a look at the balance sheet and cash flow statement. Due to lack of space, I couldn't include depreciation and comparatively minor things such as stock compensation, so you can't perfectly reconcile the numbers in the above table with net income, but it's relatively close.

Skechers has had trouble generating cash recently due to an increase in capital expenditures and a larger investment in working capital, but most of the company's capital expenditures since 2006 have been "growth" capital expenditures, as the company has been ramping up its retail division. Recent substantial inventory build-up notwithstanding, I have mixed thoughts about Skechers having invested in working capital and capital expenditures in lieu of building up cash during the past few years. Although the company has suffered from sub-10% returns on equity since the great recession began, they were substantially higher beforehand: peaking at 20.64% in 2006. It is very possible that the recent lower returns on equity were a cyclical given pre-recession returns, but I can not be certain of it since the company's recent growth has been fueled by a "faddish" product instead of substantial growth in the company's "core" business. It is also very possible, and I'd say quite likely that the pre-recession returns on equity were at a cyclical high and can not be counted on returning to that level with any consistency. A good, though perhaps not great, solution is to average the company's returns on equity from 2006 to 2010. By doing so, we get an average return on equity of 14.544%. The company has not reported its year-end 2010 numbers yet, so to get an acceptable number I took the average of the analysts' estimates as reported by Yahoo! Finance to calculate 2010's return on equity. When considering the average, I'd still like to see Skechers return more of its money to the company's shareholders either in the form of dividends or share buybacks, but only if the company thinks its stock is cheap in regards to the latter.

The increase in capital expenditures in 2010 has been a result of of the company's becoming a joint venture partner in a new Skechers distribution center in California. Upon completion later this year, this new distribution center will measure at 1.8 million square feet, and will become Skechers' primary distribution center in North America. It is hard to envision the company's investment in this distribution center as "growth," because it is replacing five existing distribution centers that, in the aggregate, measure at 1.7 million square feet. Skechers had invested $38.1 million dollars into the distribution center as of the end of the third quarter of 2010, out of a total planned $85 million. Skechers plans to invest the remainder of that amount this year.

Skechers capital expenditures are only one portion of the company's cash flow, however. There is another, arguably more important, piece of the puzzle: its efficiency in operating cash flow management. For those who are unaware, the Cash Conversion Cycle measure how long (in days), a company takes to convert its working capital into cash. The formula to calculate the CCC is DSO + DSI – DPO. Generally speaking, the lower the number, the better. There are several exceptions to this, however, which we'll cover below.

∙Days Sales Outstanding

Revenue AccountsReceivable DSO

TQ310 $1.555b $290.582mm 46.007

TQ309 $1.049b $216.034mm 52.050

Q310 $556mm $290.582mm 49.489

Q309 $406mm $216.034mm 47.251

FY09 $1.438b $232.102mm 52.666

FY08 $1.443b $182.880mm 45.632

FY07 $1.394b $177.926mm 47.615

FY06 $1.205b $185.775mm 49.564

For those who are reading and have not encountered this before, DSO (Days Sales Outstanding) is a method of calculating how many days a company – in this case Skechers – takes until it converts its accounts receivable into cash. It is an often overlooked, but very important measure that helps us gauge the company's efficiency and the quality of its earnings. The lower the DSO, the sooner the company collects what it is owed from its customers. The higher the DSO, the longer the company takes to collect those payments. The reason this is important is because while a company may have sold and shipped its products to its customers, the customers do not always pay in cash. Rather, they may purchase the goods on credit and promise to pay its supplier later. This is usually fine, but if the company's customers are not credit worthy, they may be unable to make payments to their supplier, which would result in a higher DSO number and a build-up in accounts receivable. Since cash is required to run a business (would you be willing to work for IOUs from your boss?), it's important that companies stay on top of their accounts receivable to avoid a build-up in working capital and keep cash coming in the door.

With the exception of 2009, Skechers' DSO has been creeping downwards since 2006, indicating that the company has improved its efficiency in managing its receivables. I have to give the company props for staying on the ball here – collecting on its receivables sooner means the company is more liquid and has more money to increase its inventories if necessary, buy back stock, pay dividends, or invest in opportunities for future growth. I'd like to see them keep their DSO within its historic range or continue to lower it, if possible, without relying on shenanigans like selling its accounts receivable to a third party to make their DSO numbers look better than they really are. Based upon my scouring of their financial statements, Skechers does not currently engage in such tactics, but it would be a potential red flag if they began doing so.

For anyone curious as to how I calculated the DSO numbers, I used average receivables (receivables at beginning of period + receivables at end of period, then divide by two) instead of receivables at the end of the period. It gives us a more accurate look at the company's DSO since we are accounting for the receivables that the company had going into a given period as well as what it had at the end of said period.

∙Inventory Turnover & Recent Build-Up

COGS Inventories InventoryTurnover DSI GrossMargin

TQ310 $825mm $326.651mm 2.996 91.371 47.00%

TQ309 $616mm $191.819mm 2.719 100.689 41.27%

Q310 $302mm $326.651mm 1.106 82.504 45.86%

Q309 $222mm $191.819mm 1.158 78.799 45.32%

FY09 $815mm $224.050mm 3.359 108.663 43.32%

FY08 $845mm $261.209mm 3.631 100.523 41.44%

FY07 $794mm $204.211mm 3.395 107.511 43.32%

FY06 $682mm $200.877mm 4.046 90.212 43.73%

This is really the 800-pound gorilla in the room for Skechers. As you'll see later on, Skechers is absurdly cheap based on nearly any quantitative metric that I can think of, but the rise in the company's inventories have led some to believe that the company's primary driver of growth during the past year – Skechers Shape-Ups – could be a fad and could be just a temporary blip on the radar in the footwear market. There is some evidence to support the idea that their popularity is waning. In addition to the massive order cancellations in the third quarter of 2010, remember that Skechers thinks its retail stores are useful in forecasting sales that its wholesale customers will experience. Keep that in mind, and consider the following: in the third quarter of 2010, Skechers' Domestic Wholesale and International Wholesale divisions grew revenues by 54.37% and 24.49%, respectively. Retail grew revenue by 17.40%, including contributions from stores opened during 2010. If management is correct about its retail stores being able to forecast sales that its wholesale customers will experience, there is a possibility that Skechers' retail store sales are a leading indicator of slowing growth to come from the wholesale divisions as the wholesale customers may have purchased too much inventory for the demand they can expect to experience for it. It is far from concrete and it would be foolish to rely exclusively on such a theory because there are other potential causes for the discrepancy, but it is definitely something to look for in the quarters ahead.

Unfortunately, since Skechers does not break out its revenue by product type, we can't tell exactly how much of the company's growth (or lack thereof) is due to Shape-Ups, but management has acknowledged that Shape-Up sales have slowed, and has said that they will be a smaller percentage of the company's backlog once the 2010 10-K is out. According to David Weinberg at the ICR Xchange conference, the company's current fastest-growing products are for children and sport lower gross margins than the company's products for men and women do.

Inventory build-up aside, Skechers' DSI (Days Sales of Inventory) outstanding have increased pretty significantly since 2006, meaning that it is taking more days to work through its inventory. This certainly doesn't help the company's operating cashflow, but DSI requires a bit of nuance to evaluate. A company can easily lower its DSI by slashing prices for its merchandise, but does that create value for the company? Generally not. That's why it's important to look at a company's DSI in conjunction with its gross margins – is DSI higher or lower than previous periods? If it's lower, is it because the company sacrificed its profitability to move its inventory more quickly? If it's higher, is the company being compensated for holding onto its inventory for a longer period of time in higher gross margins? If a company's DSI is decreasing and gross margins are increasing, it could have a popular product in its hands. We can even see this with Skechers, in the first nine months of 2010 its DSI decreased to 91.371 from 100.689 during the prior year, while gross margins increased to 47% from 41.27% in the prior year. We are likely to see this reverse somewhat in the coming quarters due to the slowing of Shape-Ups and increased inventory to work through, and a large portion of the uncertainty surrounding Skechers' suitability as an investment depends on the extent that this occurs.

∙Accounts Payable

COGS AccountsPayable DPO

TQ310 $825mm $231.533mm 70.958

TQ309 $616mm $160.776mm 72.307

Q310 $302mm $231.533mm 63.933

Q309 $222mm $160.776mm 69.638

FY09 $815mm $196.163mm 80.793

FY08 $845mm $164.643mm 71.079

FY07 $794mm $164.466mm 74.842

FY06 $682mm $161.150mm 72.128

The third and final part of the Cash Conversion Cycle is DPO (Days Payables Outstanding). Unlike DSI, which measures how many days it takes for a company to work through its inventory, and DSO, which measures how many days it takes for a company to collect on its accounts receivables, DPO measures how good a company is at stiffing – err, delaying payment to its suppliers. Whereas a lower number provides a company with better cashflow in DSI and DSO, the opposite is true with DPO; the higher the number, the longer a company is holding on to its cash. With the exception of 2009, Skechers' DPO have been pretty consistently in the low-to-mid 70s on an annualized basis, indicating that the company hasn't seen any improvement or deterioration in regards to holding off payment to its suppliers.

With all three inputs of the Cash Conversion Cycle, you can now see how we reached the numbers that we did at the beginning of this segment, and hopefully understand a bit more about Skechers' trends in its cash flow management efficiency.

Valuation

P/B P/E ROA EPSGrowth

SKX 1.15 7.94 13.70% 147.41%

NKE 4.12 19.22 14.80% 15.54%

TBL 1.96 16.71 7.84% 67.32%

The ROA, P/E and EPS growth figures in the above chart were calculated by using the average of the analysts' estimates on Yahoo Finance. The P/B was calculated by dividing the market capitalization of each of the companies by their respective shareholders' equity as of the end of the most recent quarter.

There are numerous measures widely used by investors to value companies. I've found that the three most common are comparing the valuations of companies in the same industry, valuing companies based upon their net asset values, and discounted cash flow analysis. Let's see how Skechers stacks up under each of these methods.

∙Comparable Company Analysis

This is a pretty simple method of valuation. Instead of focusing on the value of a company based upon its cash flows, this looks at an industry as a whole and compares the valuations of different companies to each other. Skechers would be phenomenally cheap if this were useful in valuing the company; the stock would trade at $47.95 if it traded at the same price-to-earnings ratio as Timberland does, and would trade at $55.16 if it traded at the same price-to-earnings ratio as Nike. Both of those numbers are better than double the company's current stock price. If we were to judge it based on its price-to-book value, Skechers stock would trade at $38.79 per share based on Timberland's P/B, while it would trade at an insane $81.53 if it were to trade at the same P/B ratio as Nike.

There's only one problem with this – there is no reason for Skechers stock to trade at comparable ratios to those of its competitors. Nike is the leading company in the industry and has unmatchable economies of scale for any competitor to the company through its massive distribution channels and the ability to spread its fixed costs over a much greater number of units sold. Timberland is a more diversified company in regards to its product line, while also being very good at satisfying a niche; the company focuses on outdoors-oriented clothing, boots, and accessories, for people with a comparably active lifestyle. What is Skechers' niche? That they sell shoes to people who want to lose weight without any of the requisite exercise or dieting, or that their fastest growing product line are shoes in the oh-so-reliable little girls' fashion market?

To be honest, I've never found this method of valuation useful. Not only are there substantial differences in levels of quality in companies within the same industry, there is nothing to prevent all of the companies in an industry from being overvalued or undervalued. That is the Achilles' heel of relative valuation. Sure, LinkedIn may be cheaper than Facebook, but they're both bloated pigs full of hot air.

∙Net Asset Value

Another way – and a much more useful way, in my opinion, to value a company is based on its net asset values. The simple version of this method requires an investor to look at a company's balance sheet and compare its assets to its liabilities and its market valuation. Benjamin Graham was a huge proponent of a version of this, liking companies that traded at a substantial discount to their net current asset values (current assets – all liabilities). These were some of the safest and most profitable stocks to own for a long time, because the market was placing a negative value on the company's business, which may or may not have been profitable. Both Graham and his protégé Warren Buffett (Sanborn Maps or Dempster Mill Manufacturing, anyone?) made substantial sums of money off of such opportunities, but as technology advanced, fewer and fewer of these plays became available. Today, there are no more than a handful of such companies available in the United States stock markets, and the disparity between price and value for those that are available is generally much smaller than it historically was. Although severe market corrections increase their number for a time, for the most part investing in these companies is no longer as lucrative as it once was for all but the smallest investors.

Despite net-nets (a colloquial term for the type of company described above) being in short supply in modern times, there are still great ways to value a company based upon its assets. One way is to consider all of a company's assets, instead of just its current assets, in the valuation. This is much more useful for banks and insurance companies than it is for most companies that an investor will encounter on a daily basis, because banks and especially insurers tend to have a substantial amount of their assets in securities where liquid markets exist, such as equity in other companies or government bonds and notes. Because there is usually a liquid market for such securities, there is no reason not to value them at 100% of their stated worth unless you believe there is a high risk of default or that one of a company's substantial equity holdings is extremely overvalued. Usually, though, a company's portfolio will be sufficiently diversified so that that will not be an issue.

For non-financial companies, however, book value can severely overstate or understate the value of a company's assets. A great example of this is land. For those who are not aware, land – just the raw land, not whatever buildings or improvements are upon it – is recorded at what it was purchased at. Forever. It does not depreciate, and it cannot be marked-to-market. As a result of this, after several decades, the book value of land is usually substantially below what its fair market value would be. Activist investors understand this, and have attempted in the past (I'm looking at you, Bill Ackman) to have companies spin-off their land holdings into a separate investment vehicle, believing that the sum of the value of the operating company and the operating company's land holdings are greater apart than they are as a whole.

On the other end of the spectrum, a company's equipment may be so specialized that it has virtually no resale value, and must be sold for scrap, regardless of what their carrying value is, or its land could have been purchased right before a crash in real estate prices. In these situations, the book value of a company can substantially overstate its true value. This was a problem for investors in homebuilding companies during the past few years, as fellow Fool FloridaBuilder had written about in great detail before he removed his blogs from CAPS. During the real estate price meltdown, homebuilders had carried they parcels at cost, as was proper until the fair market value of their parcels declined to below their cost. The problem was that many homebuilders were slow to write down their inventory to the fair market value, and among those that had being writing their parcels down, many of them did not write them down enough. This resulted in massively inflated book values for these companies, which caused their shares to look very cheap as they declined. Many investors got lured into a quantitative value trap and paid very dearly for it. A company's book value will not necessarily give you an accurate idea of the true market value of a company's assets.

This is the primary reason why I do not think book value is a good measuring stick for valuing Skechers – it is sitting on a load of inventory (currently at 34.65% of shareholders' equity) that may suffer from write-downs if the popularity of Shape-Ups and toning shoes in general is truly waning. That brings us to our third and final measure of value, the discounted cash flow analysis.

∙DCF Analysis

Comparing Skechers to Nike and Timberland is silly, and valuing this company based on its net asset value makes little sense. Therefore, I think discounted cash flow analysis makes the most sense for valuing the company of the three. For those who are unaware, discounted cash flow analysis – put simply – takes a company's cash flows in perpetuity and discounts them back to their present value. The great thing about DCFs is that you'll always be right . . . if your inputs are correct. Even a slight change in a company's growth rate or the discount rate used can result in widely divergent values for a company. This is a very garbage-in, garbage-out tool, and requires forecasting for years out not only for a company's growth, but its changes in operating cash flow as well. Can you determine what a company's growth rate will be ten years out, and in what order? I know that I can't, and determining what kind of changes in working capital it will take to get there – and when - is even more difficult. To be honest, I don't even think that it's possible for all but the simplest companies.

What can we do to counteract our lack of ability to read the future and still get useful data? The answer is to be conservative with our inputs so that we have a substantial margin of safety, and maybe even an upside surprise, when (not if) we're wrong. What I'm using isn't actually a DCF, so much as it is a variant of one. I think it's silly to try to even pretend to guess the working capital changes will be for Skechers ten years out, even in a conservative manner. Because of that, I have decided to use an owner's earnings variant that does not take into account changes in working capital. So, without further ado, here are my DOEs for what I think are the most likely scenarios that can play out for Skechers.

1. Shape-Ups worthless – Lower margins, negative growth

For this scenario, we are assuming that Shape-Ups are a fad and will shrink into relative obscurity, offset somewhat by increased sales from the "core" business. For this model, I've assumed negative revenue growth of 15% and 5% in the Domestic Wholesale division over the next two years, with margins decreasing to 32%, then climbing to 35% in that timeframe. After that, I estimate that the Domestic Wholesale division will resume its growth, though in the low-to-mid single digit range indefinitely, with gross margins of 37.515%, which I came to by averaging the Domestic Wholesale divison's margins from 2006 to 2009.

In the International Wholesale division, I'm only using a 5% decline in revenue in 2011, revenue staying flat in 2012, and then growing at 10% over the following two years, followed by 7% growth through year ten, after which I assume it will grow an indefinite rate of 3% I used a smaller decline for this division because it never got as overheated as the Domestic Wholesale division did, and still has plenty of room for growth in the core business to offset the decline in Shape-Ups sales. I lowered margins to 33% in the first year, then rose them to 37.54% indefinitely. I came to the company's margins by averaging the International Wholesale division's gross margins from 2006 to 2009.

I continued growth for the retail division, increasing its growth by 5% and 6% in the first two years, then growing it at its recent average of 8% until slowing it back to 5% in the sixth year as the stores reach saturation. I declined gross margins to their average of roughly 61.98%

Adding in the E-Commerce and Licensing revenue, adding the cash, subtracting the company's operating expenses and estimated capital expenditures, then slapping on a 12% discount rate, I come up with a per-share value of $16.40 (approx. 28% below yesterday's closing price).

2. Continued Growth, at a slower pace

In this scenario, I'm modeling under the assumption that Shape-Ups do not end up being a completely faddish product and that the company will continue to grow, but at a slower rate than 2010. We will be compressing margins to some extent, but not as much as in the first scenario.

For the Domestic Wholesale division, I have compressed margins to 38.52% across the board, which represents a small premium to the company's average margins in this division. I have not increased margins further in order to be as conservative as reasonably possible in this scenario. The same is true for the other divisions; I've increased margins nominally above the company's averages to provide more room for error, and have used relatively low growth rates in order to do the same. For the Domestic Wholesale division, I used 8% revenue growth for the first two years, then declining to 5% until Year 11, which uses my universal terminal growth rate of 3%.

The International Wholesale division is the same story, with margins at 38.52%. I have used somewhat higher growth rates for this division in order to be more in-line with David Weinberg's estimates, assuming 13% growth for the first year, 10% growth for the second year, 7% growth for the third year, then declining to 6% growth until Year 11.

In the Retail division, I'm modeling margins at an average of 62.98%, with growth rates of 10% for the first year, 8% for the next four years, then 5% until Year 11. The company has been putting a lot of attention on this division in recent years, and in a world where Shape-Ups retain at least some level of popularity I can envision the company continuing to invest in it.

Once again, adding in the divisions not worth detailing (E-Commerce and Licensing), cash, and subtracting operating expenses and capital expenditures, slapping on the same 12% discount rate, I get a present value of $42.44 per share, or 86.05% above yesterday's close. I would not be surprised for either of the scenarios I've presented to come true, and if Skechers manages to outperform expectations, the present value under this scenario could well be low. On the other hand, if Shape-Ups end up worthless, that number is way, way high.

Risks

Most investments have some level of risk, and Skechers is definitely one of them. Between cancelled orders, family control of the business, the potential for the company's recent largest driver of growth to fizzle out, and the company's manufacturing concentration, there are plenty of things that could do wrong for this company. Let's take a look at them in more detail.

∙Manufacturing Concentration

I didn't mention this in the rest of the blog because I didn't think it really fit well anywhere, but manufacturing for Skechers products is highly concentrated in just a few factories, mostly in China. Its top five manufacturers produced 71.3% of the company's products in the first nine months of 2010, up from 68.3% in the first nine months of 2009. If Skechers were to have a dispute with any of its major manufacturers or trade tensions with China came to a boil, Skechers could have a hard time finding replacements for its existing manufacturers in a timely and economical manner. I do not think either of these are particularly likely, but they are worth keeping in mind.

∙Shape-Ups Are A Complete Fad

If this is the case, all of Skechers' investment merits are shot unless the company can come up with a new product to make up the difference. Such speculation can't be relied upon for investment purposes, however, and would be difficult to pull off even if it could. Shape-Ups have taken this company from the stagnation it has experienced since the Great Recession to a fast-growing powerhouse. To give back a substantial amount of that growth, even at today's market valuations for Skechers stock, would be a huge blow to the company and its shareholders.

∙Inventory Problems

This ties in to the above paragraph, but Skechers needs to deal with its inventory problem as soon as possible, before its CCC numbers and margins get slaughtered. David Weinberg said that there's potential for the company's gross margins to decline to under 40% temporarily, which is better than a 460 basis point decline from its current levels. If that were to happen, Skechers would be doing little better than breaking even operationally. Even if Shape-Ups are a fad, that should "only" last for a quarter or two. You still get a lousy $16.40 per share stock price, but hey, at least management can be happy and award itself some stock for not screwing up more than it did by relying on a short-lived product often worn by people who are too lazy to do any actual work to tone their bodies.

∙Double Dip Recession

If Shape-Ups aren't a fad, this is a big concern for the company. If the economy takes a turn for the worse again, the DOEs go out the window and anything goes. Remember what happened to Skechers during the past recession? Now imagine that with a company whose primary engine for growth can frequently have a retail price point of $100 per unit or higher. It wouldn't be pretty.

∙Family Control

Like it or not, the Greenbergs have a stanglehold on this company and can run it however they please. They may never institute share buybacks or dividends, instead choosing to retain all of the company's earnings to fund its growth. Maybe they'll invest it in high ROE ventures. Maybe they'll squander the money by overbuilding their chain of retail stores, or invest it in another distribution center. Or they could just let cash pile up on the balance sheet, killing the company's ROE and taking the easy way out by compounding it in T-Bills. Do I think the Freenbergs will do any of these things with the shareholders' money? Not necessarily, the Greenbergs may surprise everyone and end up being the best capital allocators since Warren Buffett, but that's not the point. The point is that they can do whatever they want and outside shareholders effectively only have the right to vote with their feet.

Summary

By any quantitative measure, Skechers is a cheap stock. One of the cheapest "blue chips" I've seen recently. But it's cheap for a very good reason – customers cancelling orders of over $100 million dollars in the third quarter, and the risk of the vehicle of their recent success being nothing more than a fad. The fact that you can buy this company at just north of book value would be of little consolation if Skechers begins substantially writing down its inventory. The Retail division's sales growth is slowing, but despite management's claims that they can help forecast sales for the customers of its Wholesale businesses, they were still growing wildly as of the third quarter. If management's right, we could be just a quarter or two away from a massive slow-down in the company's growth.

Skechers could easily double from current levels if these fears are overblown, but if they're not, by my estimates the company's stock could decline by nearly 30%. Like I said, this type of situation isn't really my cup of tea in wide world of investing, and I have no intentions of initiating a position at least until the company files its 10-K, and probably not even then. If you were to hold a gun to my head and tell me that I had to either go long or short, I'd lean towards long simply because I would not want to be short this company if the third quarter turns out to be an isolated incident.

If you have any comments, questions or criticisms, feel free to post them in the comments below or contact me directly at hallshadowcaps at gmail.com. I am happy to provide links to anything I've cited upon request.